In this article, Rolf Neuschaefer explains how the surety market is changing in light of September 11 and the downfall of Enron, and the essential elements to a good working relationship with your surety, particularly in such uncertain times.
In the immortal words of songwriter Bob Dylan, "The times they are a-changin'." Signs of change in the surety marketplace abound. Consider the liquidations of Frontier Pacific and Amwest Surety, two active players in the small contract surety market. At the other end of the spectrum you have AIG, now limiting their focus to only jumbo net worth contractors. You have reinsurers, such as W.R. Berkley, withdrawing or excluding certain classes of bonds from their reinsurance treaties. You have some national carriers who are capping their participation on large work programs. Then came the Fireman's Fund announcement that it was exiting the surety market and selling its renewal book to a competitor.
Why is the surety marketplace changing and becoming more restrictive? With significantly higher loss ratios for the surety industry last year and prospects for still worse results ahead growing in large part out of the Enron debacle, there is a move by both reinsurers and primary surety writers to return to more consistent and fundamental underwriting standards. Surety premiums are a very minor share of the revenue base for most insurers. The business, however, holds significant exposure for large losses as the Enron case has again amply underscored.
The insurance companies who are the "parents" of most surety operations were already suffering from effects of a prolonged soft market and the affects of September 11. Therefore, if you are an insurance executive managing risk, you may view the surety business as a low revenue business with a potential for big losses. Your choices appear quite clear: exit the line entirely; restrict your writings of this line; and/or implement sound underwriting standards. That is what is happening and it very likely will affect your current bonding arrangements.
Even without the Enron mess, the surety marketplace had become too "loosey-goosey." It was almost as if anyone could obtain a bond regardless of experience, character, or financial wherewithal. Such an environment may have generated additional bond premiums for revenue hungry insurers, but it was also a disservice to the many surety principals who earned their surety credit. It was also a disservice to owners, general contractors, and other obligees that relied on the surety's much advertised "prequalification" process. Therefore, bonding programs that far surpassed the contractor's financial base or experience, the unwarranted elimination of personal indemnity, or continually lower bond rates will come to an end.
How should you deal with the changing marketplace? The first thing may be to perform a self-assessment of sorts. Has your bonding credit grown at a much faster rate than your financial base? Has the surety released the personal indemnity of the owners? And/or have your bond rates decreased several times in the last few years?
If the answer to one or more of these areas is "Yes," then you may expect some change(s). To the extent that you earned each of these benefits, you should work with your bonding agent and be prepared to support your entitlement. Surety insurers want to continue their business relationships based on solid fundamentals, and the burden will fall on you and your agent to demonstrate that you meet those new standards.
What can you do to make your account more attractive to the surety underwriter? Before addressing that question in more detail, I think there needs to be both an understanding and an appreciation of the surety relationship and what exactly the surety is doing when they write a bond for you.
The surety becomes your partner and is guaranteeing your contractual performance. The surety is effectively putting its money where its mouth is. When it approves your bond, it says to the world that it believes you have the capacity in every respect to satisfactorily complete the bonded contract. Such a relationship must have a foundation built on mutual respect and fair dealing. If viewed as a partnership, then the responsibilities of the parties to each other become quite clear.
To make yourself attractive to a surety requires in the first instance full disclosure of your past and present operations, including any affiliated business activities that can impact the operations and/or financial status of the entity for whom bonds are to be provided. You have a pretty good idea of what events will impact the financial result of a given project, and you know in the context of your overall backlog how this may impact your company's financial results.
The surety does not want or need a day-to-day accounting on each job, but if a major subcontractor defaults or there is a payment problem, it is probably a material event that should be shared with your agent and the bond underwriter. Bonding companies can deal with bad news, but what unnerves them are surprises.
The surety's approval of a particular contractor's project and/or overall work program is made based on certain financial and operational parameters. If those conditions change for any reason, the rules of fair dealing and the partnership relationship require full and timely disclosure.
Recall that what really caused the downfall of Enron was its failure to provide full and timely disclosure of its activities and financial position. That resulted in a failure of confidence in a business that relied heavily on trust. Your surety relationship is also based on trust, and if either party breaches that by failure to fully and timely disclose relevant information, it destroys that relationship. Bottom line: don't holdback or manipulate information. Neither party should ever surprise the other. Good communication is essential.
With a tightening of the surety markets, what tangible things might you do to improve both the relationship and your bonding line? You should begin by retaining a professional surety bonding agent who will take the time to understand your business and help you to communicate your story with an appropriate surety market. You should retain a CPA who is active in the construction accounting arena.
You also should preferably secure an annual certified audit with adequate supporting schedules and footnotes that fully disclose and communicate your operations and financial picture. Review level financial statements may still be acceptable for smaller accounts, but my expectation is that sureties will increasingly demand fully audited financial reports. Compilations or in-house statements are of little or no value except perhaps for interim statements and then only if they reasonably "mirror" the format of the CPA prepared statements.
The issue of personal indemnity may become a discussion point. Depending on the financial structure of your company relative to work program, how much money the owners regularly take out in the form of salary and bonuses, the amount of net worth outside the company, and/or the length and quality of your past surety relationship all will bear on whether personal indemnity is appropriate.
Some sureties will consider a homestead rider that would exclude the indemnitor's primary residence. Some may be willing to exclude specific assets, such as monies inherited by the spouse. Some may consider a personal indemnity cap limiting the financial exposure of a personal indemnitor. In the case of Sub-S entities, the surety may consider a Net worth/Working Capital Maintenance agreement to maintain a specific level of NW/WC in the corporation or personal indemnity triggers.
Make sure you have a bank line of credit that will support your business plan. While revolving bank lines create no working capital per se, they do provide a facility to obtain cash to meet anticipated or unforeseen shortfalls in cash flow. On a relative basis, contractors have always been considered more hazardous than most other borrowers. Bank of America recently announced that they were exiting all contractor bank lines of credit nationwide.
The number of banks willing to provide unsecured revolving line of credit is also growing more limited. Nonetheless, the surety views an unsecured revolving bank line as an important element in risk management. Without a bank line, the surety may be one step closer to becoming your bank of last resort in the event of a cash flow problem. Having a bank line is important for your fiscal management and to enhance your relationship with the surety.
Cash Is King
Given that the economy has become more difficult, the ability to acquire new profitable work may be more difficult, and the financial condition of owners and subcontractors may be more difficult, you would do well to manage your business to enhance your firm's working capital position. A contractor with a strong net cash position may be able to fund problems without turning to third parties, e.g., the surety or others.
The adage "Cash is king" becomes more true during difficult times. Therefore, you may expect that with a tightening surety market, your working capital level and balance sheet composition will receive more scrutiny.
If I were to summarize the foregoing points, I would say that the three essential elements to a good working relationship with your surety are:
- Understand, appreciate, and support the surety relationship.
- Encourage open and timely communication with the surety.
- Effectively manage and mitigate the risks of your business.
Bob Dylan's lyrics, "The times they are a-changin'," are immortal because change will always be with us. If you manage and effectively deal with these changes, you will prosper and grow in both difficult and good times.
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